Bank of Montreal's 9.5% reverse exchangeables linked to Amazon.com score lower on risk scale

By Emma Trincal

New York, March 16 - Bank of Montreal's 9.5% annualized reverse exchangeable notes due Sept. 28, 2012 linked to the common stock of Amazon.com, Inc. are not among the riskiest reverse convertibles currently offered, said Gurdeep Ubhi, structured products analyst at Future Value Consultants.

The payout at maturity will be par unless Amazon.com stock closes below the 80% trigger level during the life of the notes and finishes below the initial share price, in which case the payout will be a number of Amazon.com shares equal to $1,000 divided by the initial share price or, at the issuer's option, the cash equivalent, according to a 424B2 filing with the Securities and Exchange Commission.

Amazon shares can fall by 20% before investors may lose money, he said.

"Yet this type of barrier is not unusual for a six-month reverse convertible.

"What makes the risk a little bit lower with this product is the volatility of the underlying stock.

"In fact, risk for these structures is driven by volatility," he said.

Less volatile stock

The one-year implied volatility of the stock is 29%.

While this is more than the S&P 500 at around 19%, the implied volatility of this underlying should not be compared to that of the benchmark but to other stocks used in similar structures, he said.

"We see in the reverse convertibles space stocks with an implied volatility of 40% and higher, even 80%. So this is not much in comparison," he said.

The structuring of a reverse convertible involves selling a put option, he said. The more volatile the stock, the higher the premium on the put as the risk of breaching the barrier is more elevated.

"The 9.5% here is not an extraordinary high coupon because the volatility is not that high," he said.

"At the same time, this product has value because given the lower risk profile, the issuer is offering a decent coupon," he said based on some of the ratings Future Value Consultants assigned to the product.

"This type of investment is for someone looking for a decent coupon on a short-term horizon and willing to put capital at risk. As long as the underlying stock stays within the range of the barrier, you get your coupon and your principal back," he said.

"Just because it's less risky than other similar products doesn't mean there is no risk. It's not a fixed-income product, and capital is not guaranteed."

Riskmap

Future Value Consultants measures the risk associated with a product on a scale of zero to 10 with its riskmap. The higher the riskmap, the higher the risk of the product.

The notes have a 2.82 riskmap, compared with an average 4.74 riskmap for other reverse convertibles and an average 4.60 riskmap for all products.

"This indicates less risk compared to similar products," he said.

"And the terms are pretty standard. The 80% barrier on a six-month, the coupon, this is pretty much average.

"What makes the difference here is the lower implied volatility, which reduces the chances of hitting the trigger."

The riskmap is composed of a market riskmap and a credit riskmap.

At 2.47, the market riskmap is also lower than other reverse convertibles (4.22) and lower than the average of all products (3.93).

The 0.35 credit riskmap is also low as a result of the combination of the issuer's creditworthiness and the short maturity, he said.

Return score

Future Value Consultants measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions: neutral assumption, high- and low-growth environments and high- and low-volatility environments. A risk-adjusted average return for each assumption is then calculated. The return score is based on the best of the five scenarios.

The product has a 6.67 return score, which is better than its peers (6.06) and other products (6.44).

"While you don't have a very high coupon, you don't have a high chance of breaching the 80% barrier either. So the probabilities of getting your coupon without incurring a loss are higher," he said.

Future Value Consultants estimates how the product is expected to perform with its probability chart. The chart is generated using a Monte Carlo simulation using various parameters such as volatility, dividends and interest rates and running the five different key scenarios.

When using the neutral assumption, which is a risk-free growth scenario, these notes offer investors a probability of 81% to get an annualized return in the 5% to 10% bucket. The risk of incurring losses of more than 15% of principal is 15.5%.

The "best scenario" will vary depending on the type of structure. For a reverse convertible, a low-volatility environment is optimal, he explained.

"You don't want the underlying to go up or down," he said. "If it goes up above the cap, you underperform, and if it goes down, you lose money."

Under a low-volatility assumption, the outcome for investors improves with an 85.2% probability of getting an annualized return comprised between 5% and 10%. The probability of losing more than 15% is reduced to 13.5%.

Price, overall

With its price score, Future Value Consultants measures on a scale of zero to 10 the market value of the underlying components of the product as a percentage of the initial investment.

This product has a "high" price score of 7.68, compared with 6.57 for other reverse convertibles.

The score gives an estimate of the fees taken per annum. The higher the score, the lower the fees and the greater value offered to the investor.

"The price score is higher than the average. It indicates that the price of the assets is more valuable than the average product," said Ubhi.

"The issuer spent more on the options and therefore was able to offer the investor more potential return and more value."

The price score and return score are averaged to obtain the overall score of the product, which represents Future Value Consultants' opinion on the quality of a deal.

"The return and the price score are better than other reverse convertibles, which gives you a solid overall score," he said.

"The terms are very similar to other reverse convertibles. What makes the product score higher is the relatively low level of underlying volatility."

The notes' overall score is 7.17, compared with 6.32 for similar products and 6.69 for all products.

BMO Capital Markets Corp. is the agent.

The notes (Cusip: 06366Q5A1) will price March 27 and settle March 30.

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